Financial Markets and Institutions (2-downloads)

Inflation Rate

T-Bill Interest Rate

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F I G U R E   1 1 . 2

Treasury Bill Interest Rate and the Inflation Rate, 

January 1973–January 2010

Source:

ftp://ftp.bls.gov/special.requests/cpi/cpiai.txt

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Terms for Fed Funds

Fed funds are usually overnight investments. Banks analyze

their reserve position on a daily basis and either borrow or invest in fed funds,

depending on whether they have deficit or excess reserves. Suppose that a bank finds

that it has $50 million in excess reserves. It will call its correspondent banks (banks

that have reciprocal accounts) to see if they need reserves that day. The bank will

sell its excess funds to the bank that offers the highest rate. Once an agreement

has been reached, the bank with excess funds will communicate to the Federal

Reserve bank instructions to take funds out of the seller’s account at the Fed and

deposit the funds in the borrower’s account. The next day, the funds are transferred

back, and the process begins again.

Most fed funds borrowings are unsecured. Typically, the entire agreement is

established by direct communication between buyer and seller.

Federal Funds Interest Rates

The forces of supply and demand set the fed funds

interest rate. This is a competitive market that analysts watch closely for indica-

tions of what is happening to short-term rates. The fed funds rate reported by the

press is known as the effective rate, which is defined in the Federal Reserve Bulletin

as the weighted average of rates on trades through New York brokers.

The Federal Reserve cannot directly control fed funds rates. It can and does indi-

rectly influence them by adjusting the level of reserves available to banks in the sys-

tem. The Fed can increase the amount of money in the financial system by buying

securities, as was demonstrated in Chapter 10. When investors sell securities to the

Fed, the proceeds are deposited in their banks’ accounts at the Federal Reserve. These

deposits increase the supply of reserves in the financial system and lower interest rates.

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Part 5 Financial Markets

If the Fed removes reserves by selling securities, fed funds rates will increase. The Fed

will often announce its intention to raise or lower the fed funds rate in advance.

Though these rates directly affect few businesses or consumers, analysts consider

them an important indicator of the direction in which the Federal Reserve wants the

economy to move. Figure 11.3 compares the fed funds rate with the T-bill rate. Clearly,

the two track together.

Repurchase Agreements

Repurchase agreements (repos) work much the same as fed funds except that non-

banks can participate. A firm can sell Treasury securities in a repurchase agree-

ment whereby the firm agrees to buy back the securities at a specified future date.

Most repos have a very short term, the most common being for 3 to 14 days. There

is a market, however, for one- to three-month repos.

The Use of Repurchase Agreements

Government securities dealers frequently

engage in repos. The dealer may sell the securities to a bank with the promise to

buy the securities back the next day. This makes the repo essentially a short-term

collateralized loan. Securities dealers use the repo to manage their liquidity and to

take advantage of anticipated changes in interest rates.

The Federal Reserve also uses repos in conducting monetary policy. We pre-

sented the details of monetary policy in Chapter 10. Recall that the conduct of mon-

etary policy typically requires that the Fed adjust bank reserves on a temporary basis.

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